Over the past several decades, the valuation industry has matured considerably in its approach to pricing equity interests in closely held companies. When the subject of the appraisal is a promissory note, however, particularly one arising from a family transaction, expert opinions can still diverge dramatically. Comparable market data for private notes is scarce, and the risk characteristics of intra-family debt instruments often bear little resemblance to anything traded in the public markets. Some family members may be inclined to dismiss intra-family notes as worth pennies on the dollar and hardly worth the friction the arrangement can introduce, but that is decidedly not the lens through which the Internal Revenue Service (IRS) views these instruments for valuation purposes.

The stakes in this area are considerable. Note valuations figure prominently in estate and gift tax disputes, and while a portion of the IRS examination corps has grown more sophisticated in challenging both the methodologies employed and the conclusions reached, a meaningful share of auditors assigned to these matters has not. The taxpayer faces risk on both ends of that spectrum: a well-prepared examiner will probe a valuation’s weakest assumptions, while an underprepared one may seize on the wrong issues, forcing the taxpayer to litigate questions that should never have advanced past the audit. Unlike publicly traded bonds, private notes must be valued by assembling evidence from regulatory guidance, financial reporting standards, judicial precedent, and market proxies, then synthesizing that evidence into a defensible conclusion.

The Tax Court’s 2025 decision in Estate of Barbara Galli v. Commissioner has brought renewed attention to these questions. In Galli, the court confronted a fundamental tension at the heart of intra-family note planning: can a loan structured at the Applicable Federal Rate be treated as arm’s-length and reportable at face for gift tax purposes at issuance, yet valued at a discount for estate tax purposes when the lender dies? This article uses Galli as a lens through which to examine the regulatory foundations, valuation factors, preferred methodologies, and best practices governing private promissory note valuations.

Defining the Standard of Value

For estate and gift tax purposes, Reg. §20.2031-4 presumes that a note’s fair market value equals its unpaid principal plus accrued interest. The executor may establish a lower value, but only by submitting satisfactory evidence that the interest rate, maturity, collectability, insufficiency of collateral, or other factors warrant a discount. The burden rests squarely on the taxpayer.

More broadly, Reg. §20.2031-1(b) defines fair market value as the price at which property would change hands between a willing buyer and a willing seller, neither under compulsion, both having reasonable knowledge of relevant facts. This standard is conceptually aligned with ASC 820’s fair value framework for financial reporting purposes. While technical differences exist between the two, both seek the most probable price between informed, uncoerced parties.

That convergence matters in practice because the analytical frameworks developed for financial reporting can inform and strengthen estate tax valuation work. ASC 820’s input hierarchy, ranging from Level 1 quoted prices in active markets, through Level 2 observable inputs (comparable yields, credit spreads, default rates), down to Level 3 unobservable inputs, offers a useful organizing framework. For private promissory notes, Level 1 inputs are virtually nonexistent. The analysis relies primarily on Level 2 market data supplemented by Level 3 borrower-specific assumptions.

Key Factors in Note Valuation

Three authoritative sources, TAM 8229001, Revenue Ruling 59/60, and ASC 820, converge on substantially the same core considerations. The factors below, and the broader analytical framework throughout this article, are oriented to the valuation of intra-family notes for trust and estate tax purposes. ASC 820 and the financial reporting literature are referenced where they sharpen the analysis. A thorough analysis should address each of the following:

• Agreements and Protective Covenants: Covenants establishing working capital requirements, debt-to-equity ratios, and dividend limitations protect the lender; more restrictive covenants reduce risk and the required discount rate. In practice, these covenants are most useful as analytical reference points under ASC 820, where they appear routinely in arm’s-length commercial debt. Intra-family notes rarely contain any of them, and their absence is itself a risk factor the appraiser should weigh.
• Default Provisions and Default Risk: Assessed through interest coverage, fixed-charge coverage, and debt-to-equity ratios. Stronger coverage and more stringent remedies translate to lower lender risk. These corporate-credit metrics are the natural measure of default risk for financial reporting under ASC 820, where the obligor is an operating company with financial statements to interrogate. For an intra-family note, the obligor is typically an individual, and default risk turns on the borrower’s personal wherewithal: liquid net worth, recurring income, other debt service obligations, and the assets realistically available to satisfy the note at maturity.
• Financial Strength of the Issuer: A comprehensive evaluation of the borrower’s financial condition, industry outlook, management quality, and economic environment. Personal guarantees require examination of the guarantor’s creditworthiness.
• Value and Type of Collateral: The adequacy of pledged security reduces risk, but book values may differ substantially from liquidation values, and independent appraisals may be warranted for real estate or specialized assets.
• Stated Interest Rate and Term: Longer maturities increase exposure to rate fluctuations and inflation. A stated rate below prevailing market rates for comparable debt depresses the note’s value, often materially, and is one of the most common drivers of a fair market value below face.
• Comparable Market Yields: The analyst identifies debt instruments approximating the subject note’s risk profile and uses their yields as benchmarks, adjusted for note-specific differences.
• Payment History: A consistent record of timely payments reduces perceived credit risk. Conversely, delinquencies or missed payments significantly increase the required rate of return.
• Size of the Note: Smaller notes tend to carry higher risk and attract fewer buyers.

Valuation Methodology and the Discount Rate

Given the contractual nature of note payment streams, the multi-period discounted cash flow (DCF) analysis is the most widely used valuation methodology. Present value is calculated by discounting each expected future payment at a risk-adjusted discount rate:

PV = C₁/(1+r)¹ + C₂/(1+r)² + … + Cₙ/(1+r)ⁿ

where C represents the contractual cash flow for each period, r is the risk-adjusted discount rate, and n is the number of periods until maturity.

The DCF framework presupposes a stream of cash flows that can be reliably projected. Where a note has gone non-performing, with the borrower no longer making payments and no realistic prospect of resuming them, that premise fails: the model’s central input no longer exists. In those situations, a direct discount-to-face analysis, anchored to the borrower’s ability to pay and the realizable value of any collateral, is often the more defensible methodology, even though it is inherently more subjective than a DCF.

Selecting the Appropriate Discount Rate

One of the most important variables is the discount rate. In Estate of Marcia P. Hoffman v. Commissioner, the difference between a 10 percent and a 15 percent rate produced values that diverged by more than 100 percent. Two variables drive how dramatic that swing becomes: the spread between the rates under consideration and the duration of the note. A modest rate difference applied to a short-dated note moves value only marginally, but the same spread compounded over a longer maturity, or a wider spread over any maturity, can change the conclusion by multiples. The rate must capture the full range of relevant risks, including credit, interest rate, illiquidity, note size, and borrower-specific factors as outlined above in the key factors.

The process begins with identifying comparable publicly traded debt instruments and using their observed yields as a base rate. The universe of potential comparables spans U.S. Treasuries, agency bonds, investment-grade and high-yield corporate bonds, conventional mortgages, mezzanine debt, and venture capital benchmarks. Available data is robust at the lower-risk end of this spectrum but grows increasingly scarce at higher risk levels, precisely where many private-transaction notes fall.

Hoffman itself is instructive. The IRS’s expert examined a broad range of yields and concluded at 12.5 percent; the taxpayer’s expert relied on high-yield bonds and arrived at 22.5 percent. The court criticized the taxpayer for failing to demonstrate why the selected issuers were comparable to the subject note, reinforcing the principle that an expert must articulate a direct nexus between the risk characteristics of the benchmarks and those of the instrument being valued.

Musings About Liquidity and Marketability

Up to this point, we have treated lack of marketability as one of several risks the discount rate must capture. In practice, the appraiser has a choice: the liquidity gap between publicly traded comparables and the private subject note can be reflected as an increment to the discount rate, or carved out and applied as a standalone marketability discount to the otherwise-derived value. Courts have accepted both approaches, and the selection is largely a matter of analytical preference and how cleanly the supporting evidence maps to one method or the other. Estate of Verna Mae Taylor Crosby illustrates the flexibility: the expert there alternated between a standalone 20 percent discount and a 50 basis-point rate increment depending on the nature of the interest held.

The marketability discount for private debt is generally smaller than for private equity because debt derives its value from contractual payments rather than appreciation. However, high-risk private notes (small, unsecured, non-interest-bearing) may approach equity-level volatility.

Restricted stock studies provide useful empirical benchmarks, indicating average equity marketability discounts around 20 percent. Translating this into a discount-rate increment for a 10-year note yields approximately 200 basis points. Depending on the note’s characteristics and volatility, a reasonable illiquidity increment ranges from 100 to 300 basis points, with longer-duration notes justifying larger premiums.

Recent Development: Estate of Barbara Galli v. Commissioner

Estate of Barbara Galli v. Commissioner (Docket Nos. 7003-20 and 7005-20), decided in March 2025, squarely addressed a tension long familiar to practitioners: can a note bearing interest at the AFR be treated as a market-rate loan for gift tax purposes at issuance, and then valued at a discount for estate tax purposes at the lender’s death?

The Facts

On February 25, 2013, Barbara Galli, then 79 years old and residing in Florida, transferred $2.3 million to her only child, Stephen. The transfer was formalized by what the Tax Court described as a “simple note”: an unsecured nine-year promissory note bearing interest at 1.01 percent, which was the mid-term Applicable Federal Rate for February 2013. The note required annual interest-only payments with a balloon payment of the full $2.3 million principal due at the end of the nine-year term in 2022.

Stephen made timely interest payments in 2014, 2015, and 2016, each substantiated by bank records. Barbara consistently reported these payments as interest income on her personal income tax returns. The Gallis treated the transaction as a loan, and no gift tax return was filed.

Barbara died on March 7, 2016, approximately one month after receiving the third annual interest payment. Her will was admitted to probate in Palm Beach County, and Stephen served as executor. The estate included the unpaid note as an asset on the estate tax return but reported its value at $1,624,000 rather than the $2,300,000 face amount. This approximately 29 percent discount reflected the risk of non-payment and the fact that the 1.01 percent stated interest rate was substantially below prevailing market rates for comparable debt at the time of Barbara’s death. The IRS issued notices of deficiency asserting both nonpayment of gift tax and underpayment of estate tax.

The IRS’s Position and the Court’s Analysis

The IRS advanced a single theory, that Barbara made a taxable gift at issuance of approximately $869,000, supported by two alternative arguments. The first relied on general valuation principles under IRC §2512 and turned on a threshold question: whether the transaction was a bona fide loan at all. The IRS contended that the unsecured note lacked commercially enforceable terms, that Stephen had neither the intent nor the ability to repay, and that Barbara did not expect repayment, such that the instrument should be valued as something less than a true debt. The gap between the $2.3 million face amount and the note’s appraised fair market value was itself the gift. The second invoked the duty of consistency. If the estate believed the note was worth only $1,624,000 for estate tax purposes due to repayment risk and a below-market interest rate, those same risk factors should logically have applied when the note was issued, meaning it was never worth face and Barbara made a gift of the shortfall.

The Tax Court rejected both arguments. On the threshold question of whether the transaction was a loan at all, the evidentiary imbalance was stark. The IRS submitted only a single item of proof: a declaration confirming that Barbara had not filed a gift tax return. Stephen, by contrast, produced the signed note, bank records showing each interest payment, and his mother’s income tax returns reporting those payments as income. The court concluded that the IRS had neither alleged nor demonstrated facts supporting its claim that Stephen lacked the ability or intent to repay.

Turning to the gift tax question, the court applied IRC §7872, which provides a comprehensive statutory framework for the treatment of below-market loans. Under §7872, a loan is “below-market” if the amount loaned exceeds the present value of all payments due, discounted at the AFR. Because the Galli note charged interest at the AFR, the present value of all payments equaled the loan amount. The note was, by definition, not a below-market loan.

In doing so, the court reaffirmed its earlier holding in Frazee v. Commissioner, 98 T.C. 554 (1992), which established that “Congress indicated that virtually all gift transactions involving the transfer of money or property would be valued using the current applicable Federal rate.” The principle is clear: by enacting §7872, Congress replaced the traditional fair market valuation methodology with a mechanical, bright-line test. If the loan charges interest at or above the AFR, there is no gift, regardless of whether a commercial lender would have demanded a higher rate for a loan of comparable risk.

On the consistency doctrine, the court found no violation. Stephen’s position was straightforward: the gift tax treatment under §7872 and the estate tax valuation under Reg. §20.2031-4 operate under different statutory frameworks with different rules. Reporting the note at less than face value on the estate tax return simply reflects the application of fair market value principles, not any inconsistency with the mechanical gift tax test. Notably, a proposed regulation (Prop. Treas. Reg. §20.7872-1) would have imposed a consistency requirement between the two, but it was never finalized.

The court granted full summary judgment in the gift tax case (Docket No. 7005-20) and partial summary judgment in the estate tax case (Docket No. 7003-20), ordering the parties to submit decision documents by April 1, 2025.

Key Evidentiary Factors

Galli makes clear that evidentiary substance, not mere formality, determines whether an intra-family transfer will be respected as a loan. Several factors proved dispositive: the note was executed by both parties with clear repayment terms and a fixed maturity date, the interest rate met the §7872 threshold, Stephen made timely annual payments substantiated by bank records, and Barbara reported the interest as income throughout. Together, these facts established a bona fide debtor-creditor relationship the IRS could not overcome.

Perhaps the most significant analytical contribution of Galli is what commentators have described as an “all-or-nothing” framework. If a loan satisfies §7872 and the parties treat it as bona fide debt (timely payments, consistent reporting), the transaction is entirely free of gift tax. The IRS cannot selectively discount the note at issuance to extract a partial gift. But if the IRS can show that no valid loan existed at all, that there were no payments, no ability to repay, and no genuine indicia of a debtor-creditor relationship, then §7872 does not apply and the entire transfer may be recharacterized as a gift. There is no middle ground. This binary framework offers comfort to those who plan carefully and a warning to those who do not.

Conclusion

Valuing promissory notes remains one of the more demanding exercises in the appraisal profession. Practitioners must navigate sparse data, and a body of case law that reveals both the flexibility and the limits of expert judgment.

The good news is that the analytical framework continues to come into sharper focus, with each new case adding a measure of visibility.

Galli is the most significant development in this area in recent years. By confirming that §7872 provides the exclusive framework for determining whether an intra-family loan constitutes a gift, and that estate tax valuation of the same note operates under a separate set of rules, the court has validated the planning structure practitioners have long relied upon, while also sharpening awareness of its limits.

The message from Galli, ultimately, is one of discipline. Rigorous documentation, timely payment practices, consistent tax reporting, and a defensible valuation methodology are not optional safeguards. They are the price of admission to a planning strategy that, when executed properly, remains one of the most effective tools in the estate planner’s repertoire.